Convertible Notes, and their more modern Silicon Valley counterpart SAFE Notes, are a way to take an investment in a company without the time and expense of doing a "priced round."
Convertible Notes have the following terms:
- Amount invested
- Discount to the valuation in a future round
- Valuation cap
- Interest rate and term.
If you have a product built and you are generating revenue at the earliest stages then you might offer an investor a convertible note that looks like:
- $500k invested
- 20% discount
- $5m cap
- 3% interest rate, 3 year term
The discount and the cap work together to protect the investor. If the company raises its next round after this at a $10m valuation, then the Convertible Note investor would convert into equity at a $5m valuation giving them roughly 10% of the company.
If the next round valuation was only $5m then the Convertible Note investor's discount would kick in and they would convert into equity at a 20% discount to $5m or $4m giving them $500k/$4,000k, or 12.5% of the company.